University of Wollongong Research Online University of Wollongong Thesis Collection University of Wollongong Thesis Collections 2002 Decision making under sunk cost Gregory Kenneth Laing University of Wollongong Recommended Citation Laing, Gregory Kenneth, Decision making under sunk cost, Doctor of Philosophy thesis, School of Accounting and Finance, University of Wollongong, 2002. http://ro.uow.edu.au/theses/1909 Research Online is the open access institutional repository for the University of Wollongong. For further information contact Manager Repository Services: [email protected]. DECISION MAKING UNDER SUNK COST A Thesis submitted in fulfilment of the requirements for the award of the degree DOCTOR OF PHILOSOPHY from UNIVERSITY OF WOLLONGONG by GREGORY KENNETH LAING, BBus(Acc), MCom(Hons), Grad Cert Ed(Higher Ed) VOLUME 1 OF 2 SCHOOL OF ACCOUNTING & FINANCE 2002 CERTIFICATION I, Gregory Kenneth Laing, declare that this thesis, submitted in fulfilment of the requirements for the award of Doctor of Philosophy, in the School of Accounting and Finance, University of Wollongong, is wholly my own work unless otherwise referenced or acknowledged. The document has not been submitted for qualifications at any other academic institution. Gregory Kenneth Laing 19Atmh October 2002 u ABSTRACT DECISION MAKING UNDER SUNK COST Gregory Kenneth Laing This dissertation investigates whether trained professionals can be adversely influenced by sunk cost information when making financial decisions. The rational decision­ making model posits that sunk costs are irrelevant to choices between alternative courses of action. However, a review of the literature reveals that, contrary to the assumptions of normative theory, people do not always act in a rational manner when making financial decisions. Moreover, sunk costs are taken into consideration and induce economically irrational behaviour, such as committing more funds to doomed projects which can be described as "throwing good money after bad". Such theoretically irrational behaviour is the subject of behavioural (positive) theories of decision making developed in psychology. Research in cognitive psychology has recognised that people often use heuristics to simplify a decision task. To test the predicted decision outcomes of expected utility theory a model was developed based on prospect theory and image theory. In the context of prospect theory, sunk cost and framing of the decision task were manipulated. Image theory was tested by inclusion of problem space items and image compatibility questions. The model provided a suitable conceptual framework for empirically testing the "sunk cost effect". Testing for the existence of the sunk cost effect was focused on the decision behaviour of particular professional groups and evidence was gathered using survey instruments adapted from previous research. The professions surveyed were managers, accountants and financial planners. A hypothetical outsourcing task was the basis of the survey of managers and accountants. A hypothetical investment task was used to survey the financial planners and was also included in the survey of the accountants. The results of the investment task are consistent with image theory, the level of responsibility was found to be positively correlated with a higher level of funding. In the investment task the perceived level of responsibility for making the initial decision was found to be a contributing factor to escalation of commitment. An unexpected result was that both the low and high image compatibility were found to be significant predictors of the level of additional funding in the investment task. However, the statistical significance of the high image compatibility was smaller compared to that of low image compatibility. The sunk cost effect was found to be significant in both the outsourcing task and in the negative framed version of the investment task. The sunk cost effect was not statistically significant in the positive framed version of the investment task. An unexpected result was that framing produced risk behaviour that was contradictory to the prediction of prospect theory. Negative framing, which should have produced risk-taking behaviour resulted in risk-avoidance behaviour and positive framing which should have produced risk-avoidance behaviour resulted in risk-taking behaviour. The sunk cost effect was found to be nearly ubiquitous in the three professional groups. This effect was observed across a range of tasks. The strength of the effect depended on the relative magnitude of the sunk cost and other contextual factors allowed for in the survey instruments, but remained constant regardless of these influences to an observable degree. in ACKNOWLEDGEMENTS I am very grateful to my supervisor Professor David Johnstone for his guidance, help and encouragement during the entire period of this research. His exceptional research skills and attention to detail proved to be invaluable. He discerningly critiqued my meager efforts to document this research and in the process helped me to grow intellectually. I would especially like to thank Dr Barbara Geno for her mentoring. She provided skillful crafting of my efforts and guided my thoughts when I was overwhelmed with the magnitude of this thesis. My thanks also go to my home institution the University of the Sunshine Coast for granting me Professional Development Leave, which enabled me to finish this thesis. For their constructive comments and suggestions on economic theory I thank Dr Peter Slade and Colin O'Rourke. To Adrian Gardiner for taking the time out from his PhD to discuss and argue the merits of various theories and issues a special thank you. I am also very thankful to my wife Linda Laing and my sister Sharon Laing for their constructive comments, support and suggestions regarding the behavioural theories and aspects of psychology that were so important to this thesis. To my daugther Kathryn I extend a special note of thanks for all the little notes of encouragement she left for me, her sense of humor helped to keep me grounded. To both my parents Kenneth and Margaret Laing I am grateful for their support during the final stages of the research and for the sacrifices they made over the years so that I might have this opportunity. To my wife and daughter I owe a great deal for having endured all the intense pressure of the thesis years thank you for your love and understanding. IV BRIEF TABLE OF CONTENTS VOLUME 1 Title Page ABSTRACT iii ACKNOWLEDGEMENTS iv BRIEF TABLE OF CONTENTS v TABLE OF CONTENTS vi LIST OF TABLES xiii LIST OF FIGURES xvi CHAPTER 1 Introduction to the Research 1 CHAPTER 2 Normative Theories of Sunk Cost 21 CHAPTER 3 Behavioural Theories of Sunk Cost 47 CHAPTER 4 Research Design and Method 98 CHAPTER 5 The Role of Asset Specificity and Sunk Cost Information on Outsourcing Decisions: A Survey of Australian Public and Private Hospitals 130 CHAPTER 6 Contextual Effects on Decision Making by Financial Planners: Sunk Cost, Framing and Cognitive Biases 156 CHAPTER 7 The Effect of Framing and Problem Space on Outsourcing and Investment Decisions: An Investigation of the Perceptions of Accountants in Queensland 188 CHAPTER 8 Conclusions and Implications of the Research 230 VOLUME 2 BIBLIOGRAPHY 244 APPENDIX A Hospitals 274 APPENDIX B Financial Planners 284 APPENDIX C Accountants 291 APPENDIX D Supporting Statistics for Chapter 5 307 APPENDIX E Supporting Statistics for Chapter 6 322 APPENDIX F Supporting Statistics for Chapter 7 338 V TABLE OF CONTENTS VOLUME 1 Title page ABSTRACT iii ACKNOWLEDGEMENTS iv BRIEF TABLE OF CONTENTS v TABLE OF CONTENTS vi LIST OF TABLES xiii LIST OF FIGURES xvi CHAPTER 1 Introduction to the Research 1 Chapter Introduction 1 Background to the Research 1 The Theory of Rational Behaviour 2 Failure to Address Non-Rational Outcomes 3 Prospect Theory and Decision Behaviour 4 Statement of the Research Problem 5 The "Problem" of Sunk Cost 5 Sunk Cost and Rational Behaviour 6 Example 1.1 Special Order 7 Justification of the Research 8 Boundaries of the Research Problem 8 Objectives of the Study 10 Definitions 10 Research Design and Methods 12 Behavioural Model and Theories 12 Multiple Survey Design 14 Variables 17 Independent variables 17 Moderator variables 18 Control variables 18 Dependent variables 18 Statistical Methods Employed 18 Chi-square 18 Multiple Regression Analysis 18 ANOVA 19 Principal Component Factor Analysis 19 SPSS Computer Software 19 Assumptions and Limitations of the Research 19 Organisation of the Study 20 VI CHAPTER 2 Normative Theories of Sunk Cost 21 Chapter Introduction 21 Background to Normative Theories of Sunk Cost 21 Normative Theory of Decision Making 21 Rational Decision-Making Model , 22 Decision Making Issues in Economic Theory 22 Neo-Classical Economic Theory 23 Decision Making in Economic Theory 23 Relevant Costs in Decisions 24 Example 2.1 (Opportunity Cost Problem) 24 Decision Making in Expected Utility Theory 25 Sunk Cost in Economic Decision Making 26 The Problem of Sunk Cost 27 Example 2.2 Sunk Cost Decision 1 27 Example 2.3 Sunk Cost Decision 2 27 Sunk Cost Defined in Microeconomics 28 Decision Making Issues in Finance 30 Investment Appraisal Methods 30 Discussion of Investment Appraisal Methods 33 Capital Budgeting 33 Portfolio Theory 34 Return on Investment 35 Sunk Cost in Finance 36 Implications regarding Sunk Cost in Finance Models 37 Example 2.4 (Capital Budgeting Problem) 37 Decision Making Issues in Management Accounting 38 Rational Choice in Management Accounting